232 Money Markets and Financial Institutions

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232Money Markets and Financial Institutions

• Prof. Greg Duffee
• Haas School of Business
• Fall 2004

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Money markets

• Common features
• Markets for borrowing and lending at short
  maturities (one year or less)
• Very large wholesale markets (large
  transactions)
• Near zero default risk
• Our discussion will also introduce concepts of
• Primary and secondary markets
• Brokers and dealers
• Money market yield conventions

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The commercial paper market

• CP is issued by major financial and non-financial
  corporations
• For former, an important source of funding
• Maturities average about 30 days max 270
• Unsecured IOUs

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CP

• Two main uses
• Long-term financing (rolling over maturing CP)
• Matching fluctuating demands for cash
• Purchasers
• MM mutual funds, insurance companies, pension
  funds
• Advantage as an investment vehicle is very low
  risk

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CP markets

• Two types of primary markets (initial issuance of
  IOUs)
• Dealer market investment banks buy CP from
  issuer, market to investors
• Direct placements issuer sells directly to
  investors (bilateral negotiation)
• Roughly equal in size nonfinancial CP typically
  uses dealer
• Minimal secondary market (subsequent trading of
  IOUs before maturity)

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Economics of the CP market

• Facts about the market
• About 500 firms in US issue CP
• All have their CP rated by credit rating agencies
• Market effectively requires high rating to issue
  CP
• At least medium investment-grade
• For issuers, CP financing is cheaper than
  longer-term debt
• Questions
• Why cant lower-quality borrowers use the CP
  market (junk CP)?
• Why is it so cheap for issuers?
• How do issuers deal with rollover risk?

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• Answers
• Moral hazard limits issuance of unrestricted IOUs
• Covenants required for lower-quality firms
• Short maturity of CP means that high-quality
  firms do not have enough time to get into
  trouble low credit risk
• CP issuers have backup lines of credit from
  commercial banks (with covenants)

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Recent trends in CP

• Amount outstanding

• Yield spread between two CP ratings

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Themes to remember

• Nature of the market is strongly affected by
• Asymmetric information
• Transaction costs
• Temporary supply/demand fluctuations can produce
  sharp, short-run variations in rates
• Not as obvious as simple economic principles
  might suggest financial instruments are
  typically highly substitutable

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CP yield conventions

• CP yields are quoted on a 360 day discount basis
• Assumes a year is 360 days
• Interest is figured as a fraction of amount paid
  back, not amount borrowed

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• GE issues CP with a face value of 100, payable
  in 30 days. It sells today for 99.85. What is
  the yield quoted in the CP market? What is the
  bond-equivalent yield?

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Treasury bills

• ZCB with maturities 1 year or less
• Yield convention same as CP 360-day discount
• 900 billion outstanding
• About ¼ of Fed debt
• Uses the same as CP Long-term financing by
  rolling over, matching fluctuating demands for
  cash

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Treasury bills

• Investors
• Foreign central banks
• The Fed (open market operations)
• Wholesale investors MM mutual funds, insurance
  companies, pension funds, banks
• Individuals
• Lowest interest rates among all taxable
  investments
• Strong demand for zero default risk, low
  interest-rate risk

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Markets for Treasury bills

• Originally sold at auction (primary market)
• Secondary market
• Inter-dealer market is a broker market
• Brokers have computer systems on which dealers
  post prices, quantities to buy/sell with other
  dealers
• Rest of market is a dealer market
• Individuals, companies call a dealer to get
  price, make trade
• Wholesale (inter-dealer) market is a broker
  market
• Separate markets is a common feature of secondary
  trading in financial instruments

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The primary market for Treasury bills

• 60 billion auctioned each week
• Currently, weekly auctions of 26-week, 13-week,
  and 4-week bills
• Occasional cash management bills
• Purchasers are
• Dealers (competitive bidders)
• Individual investors (competitive bidding
  through dealers or noncompetitive)
• Foreign governments, the Fed (noncompetitive)
• Amounts auctioned determined by Treasury based on
  funding requirements and perceived demand
• Auctions are run by the Fed

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Auction mechanics

• The bidders
• Competitive qualified dealers, on own account
  or for customers
• Each can bid for up to 35 of entire amount
  auctioned
• Small number of big players mostly major
  investment banks
• Noncompetitive others
• The bids
• Competitive bids are pairs of quantity and yield
• Example 10 million at 1.8
• Noncompetitive bids are quantities only
• Sealed-bid method used

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Auction mechanics

• Treasury announces amount a few days in advance
• Example Thursday, June 24, announce 17 billion
  of 13-week bills and 15 billion of 26-week bills
  to be sold on Monday, June 28 (plus whatever the
  Fed buys)
• Single-price (aka uniform-price) system is used
• All winning bidders pay same price
• All noncompetitive bids are added up and
  subtracted first
• Bids at highest yield (stop-out yield) are
  prorated so total amount of bids equals issuance
  amount)
• Stop-out yield determines the bonds price

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Hypothetical bidding example

• Auction of 11.5 billion in 182-day notes
• 500 million in competitive bids

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(No Transcript)
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More about Treasury auctions

• With slight modifications, same procedure is used
  to issue longer-term Treasury securities
• Auctions used to be multiple-price auctions
• Winning bidders paid the yield they bid
• Why the change?
• Holding bids constant, single-price auctions
  raise less money
• But bidding patterns cannot be held constant
  winners curse
• Single-price bids are more aggressive
• Economic theory leans towards single-price
  empirical evidence is mixed

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Secondary markets for Treasury bills

• Trading activity is very heavy
• Combined trades of most active participants is
  about 10 turnover/day
• Reasons for trading
• Continual rebalancing of portfolios
• Nonfinancial corporations sweeping spare funds
  into treasuries
• Mutual funds adjusting to redemptions or new
  funds
• Speculation/hedging
• Positions can be used to bet on direction of
  short-term rates
• Common use hedge much interest-rate risk in
  other securities
• More discussion when we consider longer-term
  Treasury securities

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The Fed funds market

• Used primarily by commercial banks to borrow and
  lend bank reserves
• Banks keep funds on account at the Fed
• Banks with excess funds lend to those with
  insufficient funds (based on withdrawals, reserve
  requirements)
• Lending takes place in this market
• Maturity primarily, same-day borrowing of
  reserves overnight
• Term Fed funds exists
• Trade size about 25MM, daily volume 100
  billion
• Brokers usually arrange trades (thousands of
  banks)

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Fed funds

• No collateral
• Interest rates vary from transaction to
  transaction (supply/demand, not credit risk,
  which is small)
• Most commonly seen rate effective Fed funds
  rate
• Volume-weighted average of daily rates
• Rates can fluctuate dramatically because of
  market segmentation
• Same-day funds are hard to come by
• The Federal Reserve defines monetary policy in
  terms of a target effective Fed funds rate

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Fed funds yield convention

• Fed funds quoted on a 360-day add-on basis
• Also called money market basis
• Simple interest calculation, 360-day year
• Example Borrow 10 million overnight at 2.
  What is paid back?

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Yield conventions

• For the same economic transaction, rank the
  following rates 360-day discount, 360-day
  add-on, simple interest with 365-day year
• Lowest is 360-day discount Interest figured off
  of higher base amount
• Middle is 360-day add-on
• Highest is simple interest with 365-day year.
  The period over which you are borrowing is a
  larger fraction of a year when a 360-day year
  is used, so rate is smaller.

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General principles of yield conventions

• Money-market rates are used when the transaction
  is like a loan of X.
• Discount rates are used when the transaction is
  like the sale of a security with face value of X.

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Eurodollar deposits

• Eurodollars are -denominated time deposits in
  banks outside of the US
• Maturity from one day and up
• Interest received is Eurodollar deposit rate
  (competitive depends on bank)
• Eurocurrencies are deposits denominated in a
  currency that is not the home currency of the
  bank
• Multinational corporations use Euro deposits to
  simplify payment systems

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The market for Eurodollar deposits

• Major banks use Euro deposit market heavily to
  borrow and lend funds (borrow and lend deposits)
• Primary market is a broker/dealer market
• Potential borrowers/lenders contact brokers or
  major banks in London (center of market) directly
• Deposit rate is negotiated with dealer
• Primary market is liquid for maturities ranging
  from day to year
• No collateral for borrowed deposits
• Small amount of credit risk, priced into the rate

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The Eurodollar market

• Secondary market is small (Eurodollar CDs)
• Average rate of interest charged by London banks
  to lend deposits to other (A-rated) banks is
  called LIBOR London Interbank Offered Rate
• Term structure of LIBOR

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The importance of LIBOR

• LIBOR is the baseline for pricing interest-rate
  instruments floating-rate debt, interest rate
  swaps, caps, floors. Priced at spread to LIBOR
• Why?
• LIBOR is less responsive to idiosyncratic
  supply/demand fluctuations that affect other
  markets
• With issuers limited in number (Treasury), in
  ability to react quickly (Treasury, CP), or with
  institutional restrictions on trading (Fed
  funds), idiosyncratic demand shocks move rates
• With Eurodollars, major financial institutions
  can be on either side, no institutional
  restrictions to slow their reaction

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The RP (repo) market

• A market for short-term collateralized borrowing
  and lending
• Used by financial institutions, Gov
  organizations. Very large market (4 trillion
  outstanding/day)
• Mechanics
• Primary market only a dealer market
• Funds usually borrowed for next-day delivery
• Market liquid for maturities ranging from one day
  to many months (term repo)
• Collateral is usually Treasury securities, but
  other publicly-traded securities can be used

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The RP market

• Legally, RP is a matched sale-repurchase
• Buy security for 10MM today
• Simultaneously agree to forward contractsell
  security back for 10MM one days interest
  tomorrow
• Therefore for one day, lender of funds has
  unrestricted use of security (contrast with
  borrowing to buy car/house)
• Can think of RP as borrowing money or borrowing a
  security
• Terminology
• To repo (borrow money), to do repo (lend money),
  to reverse in securities (borrow securities), to
  reverse out securities (lend securities)

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Credit risk in repo

• Low and two-way
• Credit risk for party that reverses in the
  security is created by the possibility that the
  securitys price falls and the counterparty
  defaults
• Haircuts apply to collateral (maybe 0.25 for
  100 in bills, 1 to 3 for longer-term bonds)
• Haircuts reduce this risk
• Credit risk for the party that reverses out the
  security is created by the possibility of a price
  increase coupled with a counterparty default
• Haircuts raise this risk

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The RP market

• One-day RP rate closely tracks Fed funds rate
• Funds rate typically higher credit risk
• The Fed conducts monetary policy through the RP
  market
• The RP market is used extensively by investment
  banks to fund positions they take in securities
  markets
• Also popular with non-financial institutions that
  want to store funds in liquid, collateralized form

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Financing Treasurys in the RP market

• Speculating without much cash
• To go long, buy, reverse out the security no
  money down
• To go short, sell, and reverse in to deliver
• Short example a CP dealer buys 50MM (face) of
  6-month CP on Wednesday, will sell entire amount
  to customers on Monday. Goal is to hedge general
  market interest rate risk of position
• Desired hedge short-sell 50MM of 6-month
  T-bills at Wednesdays rate, close out short
  position at Mondays rate.
• But short-selling Treasurys is equivalent to
  borrowing at the Treasury rateno one will lend
  to the CP dealer at that rate w/o collateral
• More generally shorts must deliver!

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RPs and shorts

• The CP dealer can hedge using repos
• Key intuition with repos, lender of cash
  (reversing in securities) has temporary ownership
  of securities but does not face price risk of
  securities
• Hands securities back at future date at price
  fixed today
• Application
• Short-sell Treasury bills
• Lend proceeds in RP market, taking same bills as
  collateral
• Hand over bills to counterparty in short position
• Close out RP position when hedge is no longer
  needed
• Buy bills in cash market, hand over to close out
  RP position returned principal plus interest in
  repo loan pays for bills

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RPs and shorts

• Short-sellers demand for securities is a major
  reason for heavy use of repo market
• We will return to this use of the repo market
  later in the semester

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Observations on money markets (1)

• Money market instruments impose no restrictions
  on borrowers (other than obligation to pay back
  the loan)
• Borrowing without restrictions is limited to
  financially secure firms over short time horizons
• If same firms want to borrow long term, or if
  lower-quality firms want to borrow short or long
  term, restrictions are always imposed on the
  borrower
• Only default-free entities have easy access to
  long-term borrowing without restrictions

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Observations on money markets (2)

• Rates on mm instruments are linked because they
  are close substitutes for many investors and
  borrowers
• Commercial banks can borrow unsecured funds in
  Fed funds, Eurodollar markets
• Large investors who want extremely low risk
  investments can buy Treasury bills or lend in
  repo market
• Large investors willing to accept slightly more
  risk can buy CP or deposit money in Eurodollars

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Observations on money markets (3)

• Primary markets are structured to minimize
  transaction costs in linking buyers and sellers
• Methods include direct search, brokers, dealers,
  and auctionswe will deal with these more
  systematically later
• Secondary markets range from extremely active to
  non-existent
• No technological barriers to trading CP,
  Eurodollars in secondary markets, but too little
  demand to justify expense of market

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Appendix Explicit example of short-selling and
RPs

• CP dealer buys 50MM (face) of 6-month CP on
  Wednesday, will sell entire amount to customers
  on Monday. Goal is to hedge general market
  interest rate risk of position.

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• Wednesday
• Sell 50MM (face) of newly-issued 6-month T-bills
  for delivery on Thursday at yield 1.75
• Next-day overnight repo reverse out bills at
  1.75 (determines price), repo rate of 1.90
• Thursday
• Receive 50MM(1-0.0175)(182/360)49,557,639 for
  T-bills
• Hand over cash to RP counterparty, receive the
  bills
• Deliver the bills to counterpart of short
  position
• Arrange another next-day overnight repo at
  (assumed unchanged) Treasury yield of 1.75, repo
  rate of 1.90

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• Friday
• Close out original RP transaction
• Receive principal plus interest of
  49,557,639(10.0190/360) 49,560,255
• Return T-bills
• Perform under 2nd RP transaction
• Lend 50MM(1 0.0175(181/360))49,560,069
• Receive T-bills as collateral
• Pocket 186 from T-bill RP spread
• Arrange another next-day overnight repo at
  (assumed unchanged) Treasury yield of 1.75, repo
  rate of 1.9

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• Monday
• Close out 2nd RP transaction
• Receive principal plus 3 days interest of
  49,560,069(1 0.0190(3/360))49,567,916
• Return T-bills
• Perform under 3rd RP transaction
• Lend 50MM(1 0.0175(178/360))49,567,361
• Receive T-bills as collateral
• Pocket 555 from T-bill RP spread
• Buy T-bills for next-day delivery at (assumed
  higher) yield of 2

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• Tuesday
• Close out 3rd RP transaction
• Receive principal plus interest of
  49,567,361(10.019)49,569,977
• Deliver T-bills
• Perform under cash transaction
• Pocket difference of 59,644 as profit from short
  position in T-bills
• Buy T-bills at 50MM(1 0.02(177/360))49,508,33
  3